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An obstacle for Lloyds Bank despite stellar Q1

An obstacle for Lloyds Bank despite stellar Q1
It smashed expectations during a mega first quarter of 2017, but Lloyds has another major hurdle to climb. Lee Wild explains.
We've reported conflicting views on Lloyds Banking Group these past few months. In March, they were a top tip in Europe and backed to shine again earlier this month. Then, on news of the snap general election, some thought the shares might struggle to outperform. They haven't.
http://www.iii.co.uk/articles/399410/why-lloyds-banking-among-top-share-tips-europe 
http://www.iii.co.uk/articles/403298/why-lloyds-bank-upgrade-cycle-far-over
http://www.iii.co.uk/articles/406723/why-lloyds-bank-will-not-outperform-ahead-snap-election
And it's testament to a cracking set of first-quarter results - "a pretty glorious reality [for Lloyds investors]," cried one analyst - that the high street lender is able to brush aside "UK macro and political uncertainties". 
The popular bank - in which the government has now sold down its stake to less than 2% - made an underlying pre-tax of £2.08 billion in the first three months of 2017, up 1% on a year ago and 16% more than in the previous quarter. That's an impressive 10% ahead of City consensus estimates. 
Big drivers here were a 12 basis-point (bps) increase in net interest margin (NIM) to 2.8% - that's largely down to lower deposit costs after Lloyds halved the interest rate on one of its top-paying current accounts - and 35% reduction in impairment charges since the end of 2016 to £127 million, about 50% better than the market expected. 
Include £350 million of previously-flagged payment protection insurance (PPI) provisions and £200 million of other charges - half of that is money for victims of the HBOS Reading fraud - and Lloyds still doubled reported profit to £1.3 billion.  That's because it took £1.4 billion of charges a year ago, including £790 million to buy back high-interest Enhanced Capital Note bonds.
Elsewhere, a 1% improvement in underlying revenue to £4.4 billion also trumped forecasts, as did tangible net asset value (TNAV) per share of 56.5p and an extra 50bps of Common Equity Tier 1 (CET1) ratio at 14.3%.
Lloyds chief António Horta-Osório now believes margins will end the year "close to" where they are now, and that the lender remains on track to hit financial targets for 2017. That includes capital generation at the top end of 170-200bps guidance.
Slimming down the business is ongoing, too, reducing operating costs by 1% over the three months year-on-year to just under £2 billion. Further cuts in staff and elsewhere will get Lloyds to its year-end target of £1.4 billion annual run-rate savings, we're told. Only £300 million to go.
There was so much good news Thursday that Lloyds shares very briefly traded above 72p, up 7% an 11-month high. And that, remember, is after they went ex-dividend on 6 April, guaranteeing shareholders the 2016 ordinary final payout of 1.7p and a 0.5p special dividend.     
The balance sheet has been repaired, colossal fines and impairments are winding down, and Lloyds is the one of the most generous dividend payers around. However, there is an obstacle.
As the chart shows, 70p is the 50% Fibonacci retracement of the decline from 2015 high to post-referendum levels at around 50-51p. It has been a barrier to progress recently and there is further historical significance, with several touch points both as support and resistance over the past five years. 
There's the threat of a market correction, too, and low interest rates are never great for the banks. Neither is any decline in consumer confidence, more likely if the economy struggles during Brexit negotiations and inflation continues to outstrip wage growth.
That said, Lloyds trades on a still modest forward price/earnings (PE) ratio of around 10, even after today's rally, and that near-6% prospective dividend yield is attractive. Selling the rest of its stake by the end of May, as the government is tipped to do, also removes a major share overhang.

It smashed expectations during a mega first quarter of 2017, but Lloyds has another major hurdle to climb. Lee Wild explains.

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Share Sleuth: A valuation measure investors can trust

Share Sleuth: A valuation measure investors can trust
Look at the whole business, including debt, for a clearer view of valuation, advises Richard Beddard.
In my last column(http://www.moneyobserver.com/our-analysis/share-sleuth-valuation-measure-investors-can-trust) I explained how I judge whether a share is overvalued or undervalued. The basic earnings yield calculation I described is earnings (profit for the most recent financial year) divided by market capitalisation (the price of all the shares with a claim on the profit) and expressed as a percentage.
It's a measure of return on investment, and the reciprocal of the venerable price earnings ratio (price divided by earnings). If the earnings yield is, say, 5 %, we're paying more than 20 times earnings for the shares, too much for all but the very best fi rms. While good companies are likely to grow and over time yield more, there are limits to how much it is wise to pay. I don't use this simple version of the earnings yield though; my version accounts for how companies are financed.
Companies are financed in different ways -some have debt while others do not, some lease their premises or equipment (which is a kind of borrowing) and others own them outright, and some have not paid sufficient money into their pension schemes to meet their obligations, which means they have run up a debt to current and past employees.
Rather than use a company's market capitalisation, which only measures the market value of the firm's equity, I add all these forms of debt to the market capitalisation, to produce a figure known as enterprise value. It's a measure of the value of the whole business, in the same way as the market value of a £500,000 house is the value of the equity : the £100,000, say, of your own money used to purchase it, and the £400,000 you borrowed when you mortgaged the property.
Since we have changed the denominator of the earnings yield calculation to include all the debt in the market value, or price, of the company (as though we are paying it off), we do not include the cost of that debt (i.e. the interest) in the numerator, profit. The adjusted profit measure is expressed as a percentage of the enterprise value to calculate the earnings yield.
Why value the whole business, rather than just the equity component?  
When you buy shares, you buy the right to a proportionate share in the profit the enterprise subsequently earns. The profit is generated by the whole business, including those parts financed by debt. But debt distorts the returns on our investment as measured by the standard earnings yield calculation in two ways: it reduces the profit (the return) by the interest cost, and it reduces the investment (market value of equity) because a company relying on debt funding requires less equity funding.
Since the value of equity (market capitalisation) and profit determine the standard earnings yield and p/e ratio, the company's valuation is determined partly by how it's financed. But if a company were to change the way it's financed, we wouldn't expect the value of the firm or of the shares we own in it to change, any more than we'd expect the value of a house to rise just because we remortgaged.
By incorporating the value of debt into the purchase price of the company and ignoring the interest component of profit, we calculate a debt-free valuation as though we'd bought the company outright. It puts firms with differing amounts of debt on a more equal footing. It's better for us as long-term investors to base our valuations on the returns we might expect from the business itself, rather than arbitrary levels of leverage.
If that sounds complicated, you needn't worry much. Stick to companies that do not have much debt and the standard earnings yield or price/earnings ratio is a reasonable guide to valuation. If you prefer to value the enterprise and not just the equity, you can cheat. Software providers such as SharePad calculate 'Ebit' yields, a version of my earnings yield.
This article was originally published in our sister magazine Money Observer. Click here to subscribe.
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

Look at the whole business, including debt, for a clearer view of valuation, advises Richard Beddard.

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